Retirement Planning for Contractors

Most companies in the tech sector offer some sort of retirement plan, generally a 401(k), but now that you’re out on your own, the only person who is going to be sure you’re saving enough for retirement is you!

You could set up a savings account and make regular deposits, but why not set up a retirement fund and reap some of the benefits?

• Tax saving: The money you put into your retirement fund is usually either deducted from your income or counted as a business expense. In other words, if you made $100,000 and put $10,000 into a qualifying retirement plan, you’d only be taxed on $90,000. A Roth IRA is an exception to this rule; contributions are not deducted from income, but distributions are tax free.
• The concept of compound interest: If you put your money in a place where it earns interest, you’ll earn interest on the interest, hence the term “compound interest.” Einstein called it the eighth wonder of the world and Warren Buffett earned 99% of his wealth since his 50th birthday because of it. The sooner you start saving, the more you’ll have when it’s time to stop working.
• Social Security may not be enough: Fewer employers are offering retirement plans and with the prospect of social security benefits changing to who-knows-what, it’s better safe than sorry when needing supplemental income in your later years. Further, for some purposes, an IRA can be tapped without incurring the 10% early withdrawal penalty for first-time home buying— you could withdraw up to $10,000 from your IRA for a down payment. A 401(k) can be used to provide a loan for up to 50% of your 401k balance, up to a maximum of $50,000. Typical uses for tapping your 401(k) include a home purchase or education.

While traditional or ROTH IRAs are fine for low earners putting away less than $6,000/year, contractors have options that offer tax benefits, both now and in later years, and setting up a plan is easy to do.

As always, we recommend that you talk to a financial professional to give you advice on your particular circumstances.

The Basics

To begin with, make sure you’ve got this straight: you’re now a business entity (e.g. LLC or corporation), AND an employee of the business entity. Think of it as wearing two hats:

1. Company hat: When you wear this hat, you’re the boss of the company.  You wear this hat when you file paperwork with the state, do your bookkeeping, invoice clients, and pay bills.

2. Employee hat: This is where you do the work that the client has hired the company to do. You work for the guy (or gal) wearing the Company hat. You do the contracted work, collect your paycheck, and receive your benefits.

When it comes to picking a retirement plan, you’ll need to switch back and forth between company and employee hats.

Three Plans for Business Entities

There are three types of plans that work well for contractors, each a little different. Depending on how much you make now and how much you plan to make in the future, one of these should suit your needs. Each plan is outlined in brief, and a more detailed side-by-side comparison can be found in the chart below.

SEP IRA

If you’re a high earner, a Simplified Employee Pension (SEP) IRA is a great option. It’s easy to set up and you’re able to put 25% of your earnings into a SEP IRA (up to $55,000). This is 100% employer contribution (Put your company hat on!) meaning that the contribution is a business expense. If you’re an LLC, calculating earnings may be tricky when you account for self-employment tax, but your accountant can assist in how much should be put into your SEP IRA account.

Also, if you’ve waited to set yourself up, it’s still possible to establish a SEP IRA as long as you do it before filing your taxes. In other words, if you filed an extension, you have until October to establish and fund a SEP IRA for the previous year.

SIMPLE IRA

If you have employees, then a Savings Incentive Match Plan for Employees (SIMPLE) IRA may be what you’re looking for. A SIMPLE IRA has two parts: